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Bernanke May Warn of Rising Rates

Fed chairman could push for fiscal responsibility in testimony on Hill.

Federal Reserve Chairman Ben S. Bernanke takes his push for long-term deficit cuts to Congress today as a fiscal-policy deadlock threatens to reverse the decline in borrowing costs he gained through record stimulus.

Should Congress fail to avert a U.S. debt default by Aug. 2, the 10-year Treasury note’s yield, now 2.93 percent, would rise 0.5 percentage point within a month, said Priya Misra, head of U.S. rates strategy at Bank of America Merrill Lynch. Stocks and the dollar may tumble and the 10-year yield would rise to nearly 9 percent during the next decade, former Fed Governor Laurence Meyer said.

“We’re flirting with catastrophe,” said Meyer, senior managing director and co-founder of Macroeconomic Advisers LLC. “Bernanke is going to emphasize that. Irresponsible fiscal policy is a threat to the economy and makes Bernanke’s job more difficult.”

A rise in unemployment last month to 9.2 percent has increased pressure on Bernanke to consider spurring growth with a third round of bond buying, said Allen Sinai, chief global economist for Decision Economics Inc. Yet with the Fed’s balance sheet already at a record $2.87 trillion, Bernanke’s immediate goal will probably be to safeguard the economy’s gains by warning lawmakers about the damage from a default, Sinai said.

Bernanke is scheduled at 10 a.m. to begin two days of testimony in Washington on monetary policy and the outlook for the economy with a visit to the House Financial Services Committee. He appears before the Senate Banking Committee tomorrow at the same time.

Interest PaymentsIn a debt default “interest rates would likely rise, slowing the recovery, and, perversely, worsening the deficit problems by increasing required interest payments on the debt for what might well be a protracted period,” Bernanke said in a June 14 speech.

Fed officials echoed those concerns, according to minutes of their June meeting released yesterday. “Even a short delay in the payment of principal or interest on the Treasury Department’s debt obligations would likely cause severe market disruptions and could also have a lasting effect on U.S. borrowing costs,” the minutes stated.

Some Fed officials at the June meeting also said additional monetary stimulus would be appropriate “if economic growth remained too slow to make satisfactory progress toward reducing the unemployment rate and if inflation returned to relatively low levels after the effects of recent transitory shocks dissipated,” according to the minutes.

Spending CutsNegotiations between lawmakers and President Barack Obama have failed to break a logjam over the size of a deficit-reduction package and the right mix of spending cuts or tax increases to achieve it.

Obama and Republicans in Congress have sought roughly $4 trillion in cuts over 10 years. Yet House Speaker John Boehner, a Republican from Ohio, said July 9 Republicans wouldn’t accept a plan of that size proposed by Obama because it includes tax increases. Senate Republican Leader Mitch McConnell yesterday proposed a “last choice option” to avoid a default that effectively would grant Obama power to unilaterally raise the debt limit in installments.

The U.S. faces an Aug. 2 deadline for boosting the federal government’s $14.3 trillion debt ceiling. Treasury Secretary Timothy F. Geithner has said the government will exhaust options for paying its bills on that date.

‘Unsustainable Course’“The main problem now is that the political system is paralyzed and the fiscal situation is on an unsustainable course,” said Marvin Goodfriend, economics professor at Carnegie Mellon University in Pittsburgh. “That makes it more difficult for the Fed to manage the economy. The government risks shooting itself in the foot,” he said.

The Fed chief’s challenge is to press Congress to fix the nation’s finances without sounding partisan and harming the central bank’s independence and credibility, said Kenneth Thomas, lecturer in finance at the University of Pennsylvania’s Wharton School.

“This is where the world of politics and economics collide,” Thomas said. “We can’t get to the point where fiscal mismanagement threatens the economy. Bernanke will do all he can to avoid that,” he said.

So far, the concern about the deficit hasn’t driven U.S. borrowing costs to above-average levels. The yield on the benchmark 10-year Treasury note jumped 6 basis points to 2.93 percent at 11:45 a.m. in London. That’s below the average of 7 percent since 1980 and the average of 5.48 percent in the 1998 through 2001 period, according to Bloomberg Bond Trader.

‘Protracted Period’Last August, when Bernanke signaled in a speech in Jackson Hole, Wyoming, that the Fed would embark on a second round of Treasury bond purchases, employers were cutting jobs, pushing the unemployment rate up to 9.6 percent. The weakness in the economy prompted Bernanke to focus on the possibility of deflation, or a broad-based drop in prices and asset values including homes and stocks.

The economy is in better shape now than in August, though hiring remains “frustratingly slow,” Bernanke said at a June 22 news conference. Employers added 18,000 jobs to their payrolls last month, the fewest in nine months, the government reported last week.

Since Bernanke’s Aug. 27 speech at Jackson Hole, the Standard & Poor’s 500 Index has risen 23 percent to 1,313.64. The yield on the 10-year Treasury note has fallen to 2.88 percent from 3.7 percent on Feb. 8.

Growth SlowsThe economy, which expanded at a 3.1 percent annual rate in the final quarter of 2010, slowed to a 1.9 percent pace in the first three months of this year. The recovery advanced during the second quarter at a 2 percent pace, according to the median forecast of 62 economists surveyed by Bloomberg from June 28 to July 7.

Bernanke has said some impediments to growth in the first three months of the year, including energy prices and a shortage of parts to U.S. factories because of the earthquake in Japan, will probably prove temporary and that growth will rebound in the second half of this year.

Economists surveyed by Bloomberg predict the economy will grow at 3.2 percent in the third and fourth quarters. Even so, declining home prices, high unemployment and weaknesses in the financial system may restrain the recovery in the longer term, Bernanke said on June 22.

Deficit CommitmentA commitment to cut the deficit over the next 10 years could help the economy, Bernanke said at his June 22 news conference. “By taking a long-run perspective, we can help the economy by reducing the risk that interest rates might rise suddenly. We may help increase confidence” among households and businesses, he said.

The budget deficit is expected to rise to $1.4 trillion this year, according to the Congressional Budget Office. That would mark the third consecutive year the deficit topped $1 trillion.

Bloomberg News

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